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Introduction
The IASB published a final version of the international financial reporting
standard IFRS 9 – Financial instruments in July 2014, which will replace the
current international accounting standard IAS 39 – Financial instruments
on 1st January 2018. All organizations tha have financial instruments in
the statement of financial position have to replace the existing IAS 39 with
IFRS 9. The replacement has a significant impact on accounting itself, pro-
cesses, activities, decision-making and ultimately on financial statements.
This article presents the comparison between standards, its pros and cons,
a fair value accounting, impairment of financial instruments and changes in
decision making in the organizations.
www.issbs.si/press/ISSN/2232-5697/6_115-130.pdf
116 Mojca Gornjak
assumptions and judgments that are confirmed and verified by the regula-
tors and auditors (Benston et al., 2006, p. 169).
Huain (2012, p. 28) summarizes that the IAS 39 is one of the causes of
the financial crisis in 2008, so the G20, the Ecofin Council, and the Com-
mittee proposed the improvement of the standard for financial instruments
with the view to increase financial stability, taking into account:
FASB proposed that standards use the exit value of the financial as-
sets on the reporting date because assets are not in the acquisition (Emer-
son et al., 2010, p. 82). A similar criticism came from Europe, where au-
thors (Cristin & Pepi, 2013; Korošec, 2011; Linsmeier, 2011; Palea, 2014)
pointed to both positive and negative features of the introduction of fair
value accounting. Accounting at cost has a weakness in the selling of those
assets, whose value increased during the period from the purchase be-
cause the carrying amount is not adapted to the increased prices (Cristin
& Pepi, 2013, p. 1400). Such a failure value eliminates accounting at fair
value where the assets are valued in the financial statements under the
current transaction prices, which is optimal only in markets with high liquid-
ity, but as it is in terms of lower liquidity of the asset depends on the prices
realized by other players on the market (Cristin & Pepi, 2013, p. 1400).
After the year 2008 the criticism was louder and the US Congress, the
European Commission, as well as banking and financial regulators around
the world, debated about the fair value. Some critics argue that fair value
accounting contributed to the financial crisis, others claim that the fair value
of the long-term assets has no influence and potentially is not misleading if
the assets are in possession to the maturity (Palea, 2014, p. 103).
The existing model of financial reporting represents a compromise be-
tween the traditional accounting and accounting at fair value, while the IASB
announced an approximation of fair value, which is introduced and adopted
in standard IFRS 9 since it refers to all the fair value of financial instruments
(Palea, 2014, p. 104).
Reporting of fair value presents the current market situation in the orga-
nization and enables decision makers to create the usefulness and the im-
portance of information (Palea, 2014, p. 104). Similarly, Linsmeier (2011,
p. 410) defines fair value stating that fair value provides early warning for
investors and regulators, due to changes in current market expectations,
when prices on the market are falling and the risk regarding financial insti-
tutions is high. The IASB uses the standard IFRS 13 to introduce the mea-
surement of fair value and to set the definition of fair value, which refers
to both assets as liabilities in the financial statements, the definition of
transaction participants, pricing, and the use of non-financial assets. IASB
also introduces techniques of assessing the fair value in levels from 1 to
3, where level 1 represents a fair price in an active market, while level 3
represents a fair price calculated on the basis of the models.
The former president of IASB, Mr. Tweedie, in his speech announced
the end of the times when income and profits were steady, because of the
existence of uneven and fragile markets (Palea, 2014, p. 104).
where ELt is expected life loss, PDt (It ) is cumulative probability of default,
LGDt (It ) is loss given default, and dr is discounted rate for discounting ex-
pected cash flows; all parameters are upsized at the new information at
time t(It ).
Only fair value accounting should include all expected losses arising both
from changes in the credit risk (and reflects a change in PD) and from
changes in market interest rates. Fair value accounting corresponds to the
definition of the economic value of the loans (Novotny-Farkas, 2015, p. 11).
A model of expected credit losses is used for financial assets measured
at amortized cost, and for financial assets measured at fair value through
other comprehensive income and for loans and financial guarantees, which
are not measured through profit and loss in accordance with IAS 17 leases
and receivables IFRS 15 (Marshall, 2015, p. 15). The model of impairment
in accordance with IFRS 9 is based on three stages. According to the change
in credit risk, the financial instrument is placed on stage 1 or stage 2 or
stage 3.
The financial asset is classified in stage 1 on initial recognition and if the
instrument has low or unchanged credit risk. In accordance with IFRS 9, the
12-month expected credit loss is calculated and recognized as a provision
in liability in the statement of financial position and as profit or loss in the
statement of profit and loss. On the first reporting date, the organization
examines whether the credit risk of the financial instrument significantly
increases and, in the case of a significant increase, the lifetime expected
credit risk is calculated and the financial instrument is transferred from
stage 1 to stage 2. If, on the next reporting date, the credit risk signifi-
cantly decreases, there is a transfer from stage 2 back to stage 1. Transfer
from stage 2 to stage 3 is for those financial instruments for which there
are objective facts for impairment, which standard sets. Depending on the
stage, there is a different use of the annual effective interest rate for the
calculation of future cash flows (whether it is the basis for the calculation
of the gross or net book value).
As shown in Figure 1, stage 1 includes financial instruments with an
insignificant increase in credit risk at the reporting date or financial instru-
ments with low credit risk. For such assets, the 12-month expected credit
loss is recognized in profit or loss. A 12-monthly expected credit loss rep-
resents a credit loss of defaults that we can expect in the next 12 months
after the reporting date (12-month ECL = 12-monthly probability of default
× LGD × EAD). (Novotny-Farkas, 2015, p. 13) In addition, it is necessary to
point out that the calculations take into account the effective interest rate
at the time of recognition or purchase of the financial instrument. Compar-
ison with IAS 39 shows that, in the case of an existing standard, interests
are recognized as income without an adjustment for credit risks at purchase
(Novotny-Farkas, 2015, p. 13).
Stage 2 includes financial instruments with a significant increase in the
credit risk from the initial recognition or purchase, but there are no objective
conditions for impairment and the lifelong credit loss is recognized in the
financial statements (Novotny-Farkas, 2015, p. 13). If we compare a 12-
month expected credit loss with a lifetime credit loss, we can expect several
(maybe more than 10-fold) increases in provisions.
Stage 3 includes financial instruments with an objective factor of impair-
ment on the reporting date and the lifetime credit loss is recognized (but
prior to the actual default), and this is before as it is in accordance with IAS
39 (Novotny-Farkas, 2015, p. 13).
The difference between stage 2 and stage 3 refers to the recognition of
interest income. In stage 3 the calculation is based on the adjusted value
of gross book value less net claims adjustment, similar to IAS 39 (Novotny-
Farkas, 2015, p. 13).
A three-staged model of impairment on the basis of the expected credit
losses is an approximation of fair value accounting and the economic value
of the loans.
How the organization defines the significant change of credit risk can
be assumed from a questionnaire carried out by Deloitte. 41% of the bank
questioned are defining as a trigger the missed payments and 35% the
change in in the rating (Deloitte, 2015, p. 6) Additionally, 60% of banks
replied that they use the existing models of impairments, used for the cal-
culations of capital adequacy according to Basel (Deloitte, 2015, p. 11). At
the same time, however, they see the biggest challenge in the data.
In terms of assets, which fall into the measurement model FVTPL, im-
pairment has never been the subject of debate. IFRS 9 introduces a new
model of impairment from events in the past to a forward-looking expected
loss model (KPMG, 2015, p. 4). Calculations at each reporting date are
Is the business
Are the asset’s
No No model’s objective
Is the asset contractual cash flows
to hold and collect
an equity investment? solely principal and
contractual cash
interest? (5.2)
flows? (5.3.3)
Yes
No
Yes
Is it held No
for trading?
Is the
business model’s
objective achieved both
Yes
No by collecting contractual
cash flows and by
No selling financial
assets? (5.3.4)
Has the entity
elected the OCI option Yes
(irrevocable)? (5.15)
No
Yes
• Dividends generally • Change in fair value • Interest revenue, credit • Interest revenue,
recognized in P&L. recognized in P&L. impairment, and foreign credit impairment,
• Changes in fair value exchange gain or loss and foreign ex-
recognized in OCI. recognized in P&L (in change gain or
• No reclassification of the same manner as for loss recognized
gains and losses to amortized cost assets). in P&L.
P&L on derecognition • Other gains and losses • Other gains and
and no impairment recognized in OCI. losses recognized
recognized in P&L. • On derecognition, in OCI.
cumulative gains and • On derecognition,
losses in OCI gains and losses
reclassified to P&L. recognized in P&L.
Figure 2 Decision Tree for Financial Instruments at the time of Recognition in Accordance
with IFRS 9 (adapted from KPMG, 2015, p. 2)
ment) and the amount being used to back surplus (the amount remaining af-
ter investment assets having been matched with policy liabilities/potential
claim payouts) (KPMG, 2015, p. 3). Classification is the business model
of amortized cost (AC) or through other comprehensive income (FVOCI) or
in the business model through profit or loss (FVTPL). If the bond is placed
in the business model for the collection of cash flows without selling, the
SPPI-test has to be made (business model of AC or FVOCI). If the test is
passed the bond can be classified in the AC or FVOCI. If the bond does not
pass the test, the business model of FVTPL is chosen. The organization has
to consider other factors that affect the decision on the classification of the
bonds (maturity of liabilities, the nature of the obligation, etc.).
According to the current standard, the loans and receivables are mea-
sured held to maturity, and also in accordance with IFRS 9, the loans and
advances are classified in amortized cost (Linsmeier, 2011, p. 409).
Conclusions
The lack of prudence is the basis for criticism of the existing standard
of IAS 39, which is based on the perception that the IFRS allows greater
lending and credit expansion, unrealized profits and unwarranted bonuses
and dividends (D’Alterio, 2012), but the academic research in the years
after the crisis, which is summed up by the Basel Committee, shows that
there is no evidence to support the statement that fair value accounting
should have triggered, or even extended, the financial crisis.
Similarly, if we compare the financial statements of the failed banks with
information in theirs’ audited annual reports, we can see that even audi-
tors had difficulties with the impact on liquidity and the functioning of the
organization because the last audit reports were positive (Hollow, Akinbami,
& Michie, 2016, p. 298). In the United States in 2009, 140 banks failed,
of which 120 publicly released financial statements from which is appar-
ent that they were in accordance with the regulation of the relevant capital
(Linsmeier, 2011, p. 409).
Fair value accounting should not only recognize the unrealized gains but
should also require early recognition of expected losses (D’Alterio, 2012).
Additional professional literature in the field of early recognition of future
accounting losses estimates as crucial even for the supervisory institu-
tions that can carry out the corrective action at the time and not with delay
(D’Alterio, 2012). The fair value accounting identifies changes in the overall
credit risk exposure and the changes in interest rates, which are among the
key risks to which financial organizations are exposed (Linsmeier, 2011, p.
414).
The replacement of the standard that determines financial instruments
is a challenge for organizations, as there is a shift from looking back to
forward-looking. Even if the organization purchases the debt instrument at
the market at the fair price, it should still calculate the expected credit loss
on the day after the purchase.
Increased confidence in financial markets, a greater the independence
of financial institutions and a greater complexity of business and organiza-
tional structures before the crisis contributed to various decisions that were
based on a variety of technical accounting solutions (Hollow et al., 2016,
p. 299), but lost confidence can be returned with the help of the qualita-
tive characteristics of IFRS standards, which include the importance of the
reliability of the presentation, comparability, verifiability, timeliness, and un-
derstandability of the accounting data presented (International Accounting
Standards Board, 2010, p. 16).
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